Thursday, April 30, 2015

There was interesting movement in yesterday morning's markets after the (mostly expected) disappointing 1Q GDP report. Equities fell slightly as trading began, but bond yields jumped. Considering the current context of a tentative recovery in economic production and interest rates, we might have expected interest rates to decline as a result of a disappointing economic report.

I have previously speculated that the non-normal distribution of interest rate expectations resulting from the zero lower bound may be creating odd behaviors in the forward rate curve, and I think this may be an example.

This first chart describes a context where there is a negative skew in forward rate expectations that is truncated by the zero lower bound. So, the mode expected rates are higher than the median expected rates. Normally, the mean expected rate, which we might suspect to be near the market rate, would be even lower, but the zero lower bound causes a distortion in the distribution of expectations which pushes the mean higher.

As uncertainty declines, which we would expect over time as we approach a given date, the variance in the distribution would decline, and the mode, mean, and median would converge. This is one factor that I think is in play in the current forward rate market.

Now, if one were to take a naïve position on forward rates to take advantage of this adjustment over time, this would be basically a position that earns profits by taking on long-tail negative risks. If some very negative economic development comes to pass, rates will decline sharply. But, as long as the economy progresses somewhat reasonably, these profits will accrue. It's the proverbial nickel in front of the steamroller.

I am using growth in the mortgage market as a signal of economic expansion, so I am taking this position with the idea that the mortgage signal gives me insight into the likelihood of failure. The hope is to capture the gains from the trend but to exit the position if the mortgage signal weakens.

This next graph is a very simple example of the influences we might see on rates. The orange line is a hypothetical forward yield curve, based on rates rising in September and climbing at a somewhat conservative rate of 35 basis points per quarter. The blue line is a bimodal distribution, one set of investors expecting the orange line and one set of investors expecting us to remain at the zero lower bound. Here, I have set the expectation of persistent ZLB at 50%. I'm sure that is higher than the market expectation, but for now I'm not too concerned with getting the numbers exactly right.

In the next graph, the blue line remains, and it compares to today's opening forward rates (the purple line). The red line is the high mark in the forward rate market after the GDP report today. The dark blue line is a hypothetical yield curve with adjusted expectations. The expected date of the first rate hike didn't seem to move today. But, the GDP report would, counterintuitively, have had two countervailing effects on forward rate expectations.

First, the disappointing numbers would have reduced the expected slope of rate hikes. But, second, the fact that the report wasn't catastrophic would have reduced the variance in expected outcomes. In this simple model, that would mean that the percentage of investors with the ZLB expectation would fall. If the change in rates after the report reflects no change in the expected slope, then a reduction in the ZLB percentage of 3% would create today's rate changes. If the change in rates after the report reflects a decline of 2 basis points per quarter in the slope, then a decline of 8% in the proportion of investors expecting a persistent ZLB would pull us up to the later market rates.

So, my point is that as time passes and we avoid a complete meltdown, rates should move naturally up from the blue line to some version of the orange line. I also think there is another factor at work here, which is that the lack of nominal real estate investments is creating an oversupply of savings in the long term bond market, and this is dragging down forward rates in general, especially at the long end of the curve. So, right now, the orange line probably reflects a lower slope (and, there is also probably a smaller probability of remaining at the ZLB). But, in addition to seeing the median and mean expected rates move up toward the orange line as the ZLB expectations decline, we should also see the orange line move up, too, as savings finds new outlets in the real estate sector. This could happen through new building or mortgage growth, and it is clearly a convergence that will happen in a functional recovery from this point. Returns to real estate are far outside the historical norm compared to bonds.

Since each forward rate is the product of its own set of forward expectations, there is a chance that news of persistent growth in new home building or mortgage expansion could cause fairly large sudden shifts in this direction. If recovery persists and mortgages expand, an eventual rise of around 2% or so at the long end of the yield curve seems like a reasonable expectation.

Wednesday, April 29, 2015

As the FOMC finishes their meeting, forward interest rates are at a fork in the road. Since the end of 2008, when short term rates went to the zero lower bound, the expected date of the eventual rate hike has generally remained stable during episodes of QE and has moved forward in time when QE was off. When QE3 began the expected date was around June 2015. There has been some volatility in that expectation, but when QE3 ended, the expected escape date was still around June 2015. This is some pretty solid evidence of QE3's success, but I wish it had been continued just a little bit longer. Because, by ending it with some time remaining to the expected rate rise, the Fed has left open the possibility that economic stagnation would begin to push the date back again.

In fact, that is what has happened. We can see in the first graph that through the course of 2014, the expected date of the rate hike moved in a fairly tight range around June 2015. The second graph shows the date of the expected rate rise, both in terms of the number of quarters from 2012 and the number of quarters from today's date as we move through time. As we can see, since the beginning of 2015, the expected date of the first rate rise has been moving forward in time on a 1:1 basis. We are no closer to the date of the first rate hike now than we were in mid-February.

I think regulatory and market developments in the mortgage market are more important now than FOMC forecasts are. If mortgages expand, rates will rise. If they don't, rates will not rise, and if the Fed tries to raise them too much, I don't think they will be able to rise by much.

The slope of the yield curve peaked in late 2013 at about 35 basis points per quarter, and has since declined back to about 18 bp per quarter. Previous rate hike slopes during the Great Moderation have been in the 50 to 75 bp range, so this is very low. Again, I think this is highly dependent on mortgage expansion. If the Fed begins raising rates without an expansion in mortgages, the yield curve will flatten. If they begin raising rates and mortgages are expanding, then we are highly unlikely to see such a low rate of increases, no matter what the FOMC says they plan to do.

Here are four yield curves over time. At the beginning of QE3, expectations had become very low - not much different than today's. Then, by fall 2013, long term rates had rebounded significantly and the yield curve slope had steepened. But, by the beginning of 2015, the slope had declined and long term rates had fallen to a level even below the pre-QE3 level. Since January, the slope has declined slightly and the date of the first hike has moved back a quarter. Rates at the long end have remained stable.

One possibility for the extremely low long term rates and slope is that, because of the zero lower bound, expectations are not normally distributed. There may be a negative skew, so that the mode expected forward rates are higher than the median. Normally the mean expected rate would be lower than the median in that case, but the zero lower bound truncates the values at the negative end of the curve, which has the opposite effect. Regarding the slope, there could be a bifurcation of expectations, divided between rates rising at something more like the past rates of 50 bp per quarter or more, and another set of investors who don't expect a rise at all.

Or, another way to look at this is that there is simply a broad disequilibrium throughout the bond market, especially in the long term market, because the collapse in the real estate market has left a hole of $20 trillion worth of US real estate that evaporated, and the combination of a hobbled mortgage market and frictions in the own-for-rental market, that prevent capital expansion in that asset class from expanding enough to capture the large amount of low risk capital in US financial markets.

Mortgage expansion will solve both of these distortions, so I expect mortgage expansion to lead to an increased slope and a higher level for long term rates. The FOMC announcement will bring some short term volatility, but rates forward enough to have a reduced exposure to the initial rate hike decision should be more exposed to mortgage developments than to transitive FOMC policy statements.

While the government continues to harass mortgage lenders, which is understandable given the consensus view that this is all their fault, mortgage originations appear to be on the rise. This seems to be showing up in the Fed's H.8 reports, and Flow of Funds looks like mortgage levels are finally ready to rise. But, this isn't a done deal. There are even some more regulatory hurdles coming later this year. And, it seems like there will be a lot of pressure to undermine housing markets if we start to see the 10-15% annual price increases that must be around the corner if mortgage markets begin to function.

In the meantime, I am positioned, tentatively, for this transition, but I consider tomorrow's FOMC announcement to be mostly a source of troublesome volatility until permanent factors become better established.

Tuesday, April 28, 2015

This graph shows the long term decline in real housing expenditures. Contrary to popular narratives about the housing boom, there is no indication here of overbuilding. On the contrary, as a proportion of total consumption, households have been bidding up the price of a dwindling housing stock.

This topic is a little bit tricky because of the position of the owner-occupier as both a consumer and a supplier. It is tempting to think of rising home prices as a product of high demand. But, if we think about this carefully, the housing "bubble" narrative is actually saying that households were being induced into being housing suppliers. When a household takes on a new mortgage and buys a new home, they are increasing supply by investing capital into a property which will provide additional real supply over time, as measured in inflation-adjusted rent. It is not possible to say whether they are increasing demand. The best window into housing demand that we have comes from the measures of nominal and real rent and imputed rent.

A context with stable nominal expenditures and declining real expenditures suggests a relatively stable demand and a shortage of supply. If we truly had an oversupply of housing, then real and nominal housing expenditures would have looked more like this:

Maybe the BEA messed up the imputations of owner-occupier rent, and nominal housing expenses were actually going up. As a double check on that, here is an estimate of housing expenses with no imputations. This is an estimate of cash expenses for all households, including tenant rent and owner-occupier gross interest expense, direct expenses, subsidies and transfers. This was actually declining during the boom.

The trend in cash expenses is much flatter if we only include the real portion of mortgage interest. As I have described before, the inflation premium portion of mortgage interest is really a purchase of home equity by the borrower from the lender, when considered in real terms. So, much of the decline in cash expenses is the product of the decline in expected inflation, which reduced nominal mortgage payments. That is a kind of imputation, so I have not included that adjustment here. But, even if I did, it basically gets the housing expenses trend just back up to a flat line.

Without a rising level of nominal housing expenditures, we can't explain the housing boom as a combination of both rising demand and rising supply. But, what if the measure of rent inflation is somehow wrong because of the difficulties of estimating rent imputations? What if housing expenditures looked like my counterfactual graph, above, with level nominal spending, and an oversupply of homes which meant that real housing consumption was actually increasing? That seems like the outcome we would have to see if there was a "bubble" in home construction and home ownership, but no increase in nominal home expenditures.

First, here is a graph of core inflation over time, separated between Shelter inflation and non-Shelter Core inflation. (I have used a static weight for Shelter Inflation equal to 40% of core, which I think is a good approximation of the shelter weight over time.) First, without talking about counterfactuals, just looking at Core minus Shelter Inflation over time, we can see that shelter inflation has been high since 1995. Excluding the shelter inflation, core minus shelter inflation has moved between 1% and 2% for 20 years. I believe that this reflects supply constraints, and has been pushing monetary policy too low, to the extent that the little inflation we have seen has been interpreted as a demand phenomenon.

But, what if we apply our housing counterfactual? What if real housing consumption has been rising, and this has been mismeasured as inflation? In that case, Shelter inflation should have been running below Core Inflation. In this graph, I have adjusted Shelter inflation so that it is slightly below Core inflation instead of slightly above it, which is the inflation level that would correspond to our housing oversupply counterfactual. In the counterfactual, Core Inflation has been running between 0% and 1.5% since 1997.

So, unless someone can unearth data that points to rising nominal housing expenditures, relative to total consumption, it seems to me that there are two possible narratives to choose from:

1) There has been a decades long shortage of housing, combined with relatively tight monetary policy that has contained non-shelter inflation generally below the 2% target rate.

or

2) There was a housing bubble, which created an oversupply of housing in the late 1990s and early 2000s. The flood of money into the housing market created an increase in the real housing stock, relative to incomes. This means that RGDP has been running at much higher levels than previously thought and inflation has been lower than previously thought.

If we believe the data, narrative number 1 is the correct narrative. But, if we are going to believe narrative number 2, then the narrative includes neither secular stagnation nor loose monetary policy before 2006. There is an awful lot of data that would have to be massaged in order to tell a story that includes an oversupply of housing, secular stagnation, and loose monetary policy. That's the story I keep seeing in the papers. The data tells the opposite story. (In fact, secular stagnation just might be coming from the constraints we have placed on housing supply.)

Monday, April 27, 2015

What do you think a graph of down payments in the 2000s would look like? It would be plummeting, right? That's how the banks pulled marginal households into the market, right?

Here's a graph from the FHFA of down payments on conventional mortgages on all homes, nationwide. (This is 100 minus the Loan to Price value in the source data.) From 2000 to 2005, down payments became substantially larger.

And, notice when they suddenly dropped to much lower levels: 2006 and 2007 - after house prices had leveled off and began to fall. The period where I have been arguing that the Fed was already creating a liquidity shortage. Then down payment levels recovered in 2008. Of course, by 2007, and especially by 2008, mortgage originations were very low. In fact, conventional loan originations had begun to fall by 2004 and 2005.

But, this is just conventional mortgages, right? Wasn't the real damage in subprime? Here is a table from the Demyanyk and Van Hemert paper that I referenced the other day. This lists several characteristics of subprime loans. This comes from loan level data from CoreLogic. Combined Loan to Value ratios on these loans rose from 79.4% in 2001 to 85.9% in 2006. This includes all loans, not just the first lien mortgage. Here we see a mirror image of the downpayments in the conventional loans, with a reduction in down payments as a percentage of the home price of 6.5%. That is something.

But, take a look at the average loan size. It grew from $126,000 in 2001 to $212,000 in 2006. That means that in dollar terms, in 2001 the average down payment was $32,690 and in 2006 it was $34,799. In dollar terms, down payments rose slightly, even among subprime loans.

Further, let's think of a hypothetical household moving from renting to owning. Using data from the Flow of Funds report and the BEA, for total owner-occupied real estate value and total imputed rent, the national average price to (annual) rent ratio was 15.6 in 2001 and 20.0 in 2006. (This is more conservative than the rise implied by the Case-Shiller indexes.) So, an average family in a home with $848/month rent could have purchased that home in 2001 for $158,690 - the average price for homes purchased with subprime loans that year. But, by 2006, rent on that home would have risen to $979/month and it would have cost $234,902. Even if they used a subprime mortgage, the average down payment for the average family went from $32,690 to $33,121.

Certainly averages hide some details about the distribution of mortgages. But, it seems unlikely that broad based changes in down payments could have been a causal factor in creating unsustainably high home prices.

This also confirms another pattern I have been seeing, which is that rent inflation has been high. That same hypothetical house was fetching more of the median family's income in 2006 than it had in 2001, even though real median household income had risen slightly. Households were not purchasing larger homes (or, more accurately, homes which would fetch higher rents). The average home purchased with a subprime loan in 2006 had rent that was a slightly larger portion of median family income, but over that time, subprime loans had grown from 7.6% to 23.5% of total mortgage originations. Using Debt-to-Income, Mortgage Rates, and Average Loan Size from the Demyanyk and Van Hemert table, I estimate that the average income of subprime loan borrowers increased by about 35% from 2001 to 2006. The average subprime loan borrower in 2006 was moving into a home with a lower rent/income value than the average subprime loan borrower had in 2001.

Demyanyk and Van Hemert also show that during the 2000s the premium borrowers had to pay via higher interest rates for having a low down payment was increasing as the boom progressed.

There certainly are some mysteries to be uncovered regarding the explosion of subprime lending in the 2000s, but the evidence suggests that, even among subprime borrowers, the trend from 2001 to 2006 was of higher income households making relatively larger down payments on homes with lower imputed rents relative to their incomes. And that understates the downsizing they were engaging in, because rent inflation meant the same rent was getting less home. Higher prices were not coming from lower income households making smaller down payments on larger homes.

Friday, April 24, 2015

I was reading through some old housing posts, and was reminded of this article from Yuliya Demyanyk at the St. Louis Fed, where she describes some research by she and Otto Van Hemert regarding the subprime market in the 2000s. They find that teaser rates, cash out loans, high LTVs, and poor borrower creditworthiness were not significant causes of delinquency.

"(T)he subprime crisis
did not confine itself to a particular market
segment, such as no-documentation loans,
hybrid loans, cash-out refinance loans, etc.
It was a (subprime) market-wide phenomenon.
For example, borrowers with mortgages
that carried a fixed-interest rate—the
rate that will not reset through the entire
term of a loan—had very similar problems
to borrowers with hybrid mortgages. Borrowers
who obtained a subprime mortgage
when they bought a home had the same
problems in 2006 and 2007 as those who
refinanced their existing mortgages to
extract cash. Borrowers who provided full
documentation and no documentation followed
the same pattern."

Here is a chart from the article of relative delinquencies, by year of origination and FICO score. Delinquencies increased across the board. And, remember, by 2006, the Fed Funds rate was already at its peak level. The loans which were part of the spike in delinquencies had been initiated at the top of the rate cycle. These delinquencies couldn't have had anything to do with rising rates after a teaser period. Also, note that the number of subprime loans topped out at just under 2.3 million in 2005. There were still about 1.8 million issued in 2006, and in 2007 this dropped to 316,000. So, in terms of quantities of defaults, the 2006 vintage is the heart of the crisis.

Demyanyk and Van Hemert find that the overwhelming cause of delinquencies in the 2006 and 2007 vintages was falling home prices.

The last home buyers to have homes with an average market value above the purchase price 12 months after they bought it were the February 2006 buyers. Buyers in December 2006 were sitting on losses two years after their purchases of 17% nationwide and 27% in the cities in the S&P/Case-Shiller 10 city index.

Demyanyk ends the article with doubts about the predictive value of FICO scores. But, it seems obvious to me that FICO scores were doing a pretty good job of describing credit risk until a financial tsunami hit in 2006 and after. In 2Q 2007, an unprecedented and sharp divergence between housing prices and real long term bond prices began. At that point, when home prices really began to drop, home prices weren't falling back to a normal level. They were moving away from longstanding equilibriums.

For decades, returns on homes (net rent as a percentage of home values) roughly matched 30 year mortgage rates minus an inflation premium (because homes are a real asset that gains value over time and mortgages are in fixed nominal terms.)

In 1995, homes were earning about 4% Net Rent/Price, expected inflation was about 3.5%, and 30 year mortgages were running about 8%.

In 2005, homes were earning about 2.5%, expected inflation was about 2.5%, and 30 year mortgages were running about 6%.

You get the idea. Home returns and inflation generally added up to something in the ballpark of 30 year mortgage rates. The returns in 2005 were a little on the low side, but within historical ranges. (I suggested in this post that the chronic shortage of housing has led to a long term trend of above normal rent inflation, and that this could mean the inflation premiums for houses are higher than inflation premiums for, say, TIPS bonds, and that could explain the slightly lower home rent yields.)

Since 2010, homes have earned about 4%, inflation expectations have been about 2%, and 30 year mortgage rates have been about 4%. Homeowners are earning as much on a real asset as the lenders are earning on a nominal asset.

This simply can't represent an efficient price level. I mean, I suppose you could argue that because volatility in home prices has been so high, home owners are now earning a risk premium. After all, stocks are real securities and they earn a premium over nominal bonds. But, that's a bit of a circular argument. To make that argument, you have to say that home prices had to fall and that the new low prices are justified by the fall itself.

So, the story that the fall in home prices was inevitable and reasonable has two elephants in the room that it must disregard. (1) High rent inflation during a time period where homes were supposedly over-supplied, and (2) A home price level during the supposedly inevitable bust which is completely outside the realm of historic ranges or theoretical norms.

Thursday, April 23, 2015

I mentioned the other day that it looks like things are turning up for a position that is long housing and short bonds. On the bond side, I expect long term rates to move up as housing begins to attract capital again, and short term rate expectations should move up as GDP growth accelerates. Short Eurodollar contracts in the early 2018 time frame seem like the best spot to target those movements. That time frame should capture most of those rate movements while avoiding unrelated Fed discretionary moves regarding the date of the first Fed Funds rate hike or the cyclical peak in the Fed Funds rate. On the other hand, if long term rates on housing and treasuries converge, generally, then there are probably more gains to be captured farther out on the yield curve as the entire curve moves higher. My main concern there would be that aggressive hawkish postures by the Fed could hold those rates down while leaving rates in the 2016-2018 time frame relatively unchanged or even higher. If the Fed somehow moves into a dovish position, long term rates and mid-term rates would rise, due to positive market conditions and inflation expectations, and this would also seem to favor that 2018 time frame.

Here's yesterday's graph of new home sales and home prices over time. We can see here how home sales have suddenly moved up sharply, but still have a long way to go (although housing starts have not seen this same sharp move up in the last couple of months). I have already noted that mortgages have begun to expand at the banks. I expect home price growth to begin to turn upward again, also. Note in this graph how home prices tend to lag home sales. This supports my general thesis that home prices are sticky, and that much of the speculative activity in the 2000s boom revolved around that. I had originally expected to be able to value homebuilders, in part, as land speculators. But, their business and their valuations seem to be much more closely tied to sales volume than price. I think this is partly because of this price stickiness issue. The outlet valve for housing when the equilibrium price is moving sharply is the new home builders. The quantity response moves through the homebuilders.

On the housing side, one way to take a position would be to take long exposure in a homebuilder that would be expected to gain the most from positive surprises in new home sales. Here are two earlier posts on the idea. Here, we really want to aim for a highly leveraged, high beta firm. In addition, homebuilders tend to be sitting on large amounts of tax assets, many of which are still off the balance sheets at the firms that have struggled the most through the housing bust. I had hoped to find a clever valuation method for these firms, specific to the situation. But, generally, it looks to me like the homebuilders tend to have a pretty stable ratio for Enterprise Value / Revenues of 1 or slightly higher. It tends to move up somewhat when growth expectations or margins are running high, but it appears to be a stable valuation metric for the industry as well as for individual firms.

It is running high now, partly because of those tax assets, although the tax assets don't generally amount to a large sum for the largest firms at this point. Mostly, this valuation is running high because of growth expectations. Analyst 2 year revenue growth for the industry is averaging about 33%, but I suspect that the market price reflects growth at more like 50%. This isn't as crazy as it sounds. Looking back over the past 20 years or so, 2 year growth levels during recovery times have commonly run in the 50-60% range.

In the next graph, homebuilder enterprise values are compared to current revenues and prospective revenues. My "bullish" 2016 revenue level here equates to 2 year growth of about 66%. That is similar to growth rates since 2012, and would put home sales in 2016 only back up to about the levels of the mid-1990s, so I don't think that is excessive in the current climate. And, that puts industry-wide valuations, with some modest annual gains, at the range of baseline valuation levels when growth might be expected to moderate in a few years.

Because growth rates seem to be somewhat priced in, I am not sure how much gain is available, industry-wide, for a bullish forecast. There might be 25% or more in industry-wide excess gains if my bullish forecast comes to fruition over the next 2 years, but I think the gains for the entire industry may be dependent on the length of time the recovery is allowed to run, and there is too much political/monetary uncertainty there for valuations to reflect hopeful growth more than a few years in advance. So, what industry-wide gains there may be may happen in real time as the recovery progresses.

For this first phase, I think the gains will come mostly from the more distressed firms. In these charts, the firms are arranged by leverage (red bars). Debt here is shorthand for Enterprise Value minus Market Capitalization. The blue bars reflect growth forecasts. Dark blue is revenue, and light blue is how that growth would flow to equity holders, given current leverage levels. Growth expectations are fairly tight across the industry, so the inferred equity growth is strongly related to leverage.

In the next chart, the measures are the expected market cap with an Ent.Value/Revenue ratio of 1 at 2014 revenue levels, 2016 forecasted levels, and my bullish 2016 levels. All values are as a percentage of the current market capitalization. All enterprise values have tax assets deducted (including off balance sheet allowances). We can see that the EV/Rev. value is somewhat lower than most of the market capitalizations of the more healthy builders, and for the industry as a whole. The builders who are highly leveraged are currently priced below that level. (For instance, Hovnanian (HOV) would need to nearly double in price for its Enterprise Value to equal its current revenues.) This makes sense, as the distress caused by the over-leveraged balance sheets creates added risk, so if a recovery does not come, these firms will likely suffer valuation losses. But, these are the firms which offer the most upside from a bullish market. And Hovnanian really is the firm most aligned to this proposal.

Betas for the firms also tend to follow the same pattern as the leverage levels, with Beazer, Hovnanian, and KB tending to have higher betas than the other equities. I think this is a case where extremes in potential outcomes and betas can make it difficult for theoretical models to apply to actual financial performance. Even Hovnanian tends to have a beta less than 2. I think part of what happens is that things like operating and financial leverage do create a multiplier effect as revenue ebbs and flows. But, additionally, the leverage also serves as a sort of optimization of a certain set of expectations about revenue growth. So, some of what is actually beta will be measured as alpha, depending on how optimized that firm's leverage is to actual revenue growth.

Here is a graph of equity returns, normalized to current share prices. Notice that since the crisis, Hovnanian has exhibited a beta that looks like something around 3 (compared to the industry), which is more in the range of the estimate for expected returns above. KB and Beazer have also occasionally shown similar behavior. But, what we see are separate periods. Its measured beta (compared to the industry) has ranged around the mid 1's during this time, depending on the specifications you use. But, depending on how conditions differed from expectations, the beta embedded in its current business model came through as very high levels of alpha (positive or negative). Then, over the past two years, as housing has progressed more or less as expected with few positive growth surprises, along with a pause in home price appreciation, Hovnanian, has acted kind of like a call option, with a time decay, because by necessity their business model is optimized now for higher growth rates, until they move back toward their organizational capacity and optimal capital structure. It also probably reflects less faith that tax assets will be claimed.

Statistically measured betas simply can't capture these nuances. Good timing in these matters can capture gains that market-wide statistical analysis won't find. Good timing ... that should be easy. I mean, what could be so hard about that?

Wednesday, April 22, 2015

I have been looking at my Treasury/Housing trade, and in the process uncovered some more data that informs my ongoing discussion of housing.

Here's a graph of new home sales and home prices over time. Note in this graph how home prices tend to lag home sales. This supports my general thesis that home prices are sticky, and that much of the speculative activity in the 2000s boom revolved around that. On my housing position, I had originally expected to be able to value homebuilders, in part, as land speculators. But, their business and their valuations seem to be much more closely tied to sales volume than price. I think this is partly because of this price stickiness issue. The outlet valve for housing when the equilibrium price is moving sharply is the new home builders. Possibly the laggardly price reaction leads marginal renting households to move to homeownership. The quantity response moves through the homebuilders. Then, when the price needs to move down, new home sales plunge and inventories grow. (I view homes as a sort of long term security. Rents rise and fall as a function of supply and demand. But, home prices can move independently of supply and demand, because of the changing discounted value of future expected rents. I believe that explains most of the price increases we have seen in the past 15 years.)

Edit: This also works well with this description of the business cycle, where I speculated about the inability of the yield curve to remain an unbiased predictor of future rate changes when the yield curve needs to invert. My hypothesis is that when long term real rates are falling, intrinsic values of homes will rise, because rent and expected rent will be more stable than the fluctuations in long term interest rates that would be causing home values to rise. So, liquidity is necessary for long term securities to find equilibrium rates. If a lack of liquidity is a cause for the correction, this mechanism fails. And, what we see in three of the recessions in the above graph is the quantity of new housing collapsing while the peak in home prices lags. That makes sense in the context of this business cycle hypothesis. The lack of liquidity means that there is no nominal demand for new supply. But, because long term real rates are lower, the prices of the existing stock of homes would still compare favorably to other long term securities. The level where the yield curve stops inverting would be where there is a balance between the market rate of long term bonds and the availability of liquidity to push home prices up to the non-arb price level. In this cycle, things got so out of whack that even with short term rates near zero and an upward sloping yield curve, there is still a lack of capital able to push real estate prices up to a level of equilibrium returns relative to treasuries.

We can also see the inevitability of the recession that came out of public misperceptions of housing. Home sales began plummeting all the way back in early 2006. Extremely recessionary signals were very clear by then. But, there was such a misplaced consensus that housing was in the midst of a speculative fervor and that speculators needed to learn that sometimes home prices can decline. Since home buyers and banks weren't actually being irresponsible, a highly unusual decline of 5% or even 10% in nominal home values didn't lead to much upheaval. We had to push home prices down by more than 25% to make our point. The Federal Reserve's estimate of household real estate market values had never declined in value, going back to WW II more than momentarily. But, we managed to create a 25% drop. That'll learn 'em!

This is one of the sleights of hand that creates a misperception of the crisis. Everyone is convinced that the housing boom was created because speculators were convinced that home prices can never fall. Then, the conventional wisdom says, housing prices did fall, and all of those speculators were proved wrong, and wise people like us were proved right. But this is deceptive. That conventional wisdom would have been proven right if home prices had dipped 5% and there would have followed a banking crisis. But that isn't what happened. What happened was that banking and housing markets were continuing to muddle along until there was a widespread collapse that included, among other things, a full 25% drop in home prices. We do not now, and will not ever - nor should we - have a housing market or a banking industry that perpetually prepares for a 25% downturn in home prices. Now, you might argue that the huge drop in home values was somehow a product of the housing upheaval itself. But, now we are in the realm of question begging. This is a different, much weaker, argument, and must admit to the large influence of tight monetary policies, arguably as far back as 2006, but undeniably as late as 2008.

I get the sense that there is a plurality agreement to the view that the outcome we had was preferable to an outcome where home prices never collapsed, because we needed to learn a lesson. The fact that this view is so widely held that its proponents can push it without a thorough review of the mitigating evidence does not make it any less destructive or odious.

Every post WWII recession, except for the year 2000 was associated with a brief pause in the growth of real household real estate values, give or take a couple of percentage points. We had achieved that by the end of 2006. By the time Bear Stearns had to recapitalize some hedge funds that were exposed to the subprime mortgage market in June 2007, we were well into unprecedented territory. I have gone over the timeline after that here,here, and here, and of course, there was the Sept. 2008 FOMC meeting after the Lehman failure.

One issue I have noted is that rents were rising through the 2000s, which is strange if sticky prices were pulling more homes onto the market. But, I think most of what was happening was a transfer of households from renting to owning and from living in multi-unit homes to single unit homes. As we can see in this graph, multi-unit building was very low during the boom. So, in total housing supply was still stifled. I wonder if this is related to the problems of restricted building in the high cost of living cities that tend to have rent controls, zoning regulations, and anti-development sensibilities. Possibly this graph is sort of showing us two Americas: The coastal cities which are dominated by multi-unit housing, and where we aren't building much any more, even though there is a huge housing shortfall, and the remaining areas where we lounge in our spacious "McMansions". Rents are rising much faster in the large cities. We can see in the graph that the building levels in the 2000s weren't particularly high (especially considering that population has grown over time), but the building was highly concentrated in single family homes. Even now, when housing has been stifled for so long, vacancies are low, and rents are rising, multi-unit housing starts are not particularly strong.

And, compare the home sales graph above to this graph on housing starts. In addition to the permanent stagnation of muti-unit housing, we can see that single-unit housing has become increasingly institutionalized. In this graph, even just looking at single-unit housing starts, they were not high compared to previous recovery periods, especially when we factor in the larger population base. But, home sales were much higher than they had been in previous periods. Housing starts includes homes built by or for individuals and homes built for rent. So, I think part of what we are seeing here is the institutionalization of home building where homebuilding corporations handle the increasingly difficult regulatory burdens of housing development.

So, the first graph above reflects at least four factors:

(1) increasing quantities of new single unit homes because of price stickiness in the face of interest rate related price increases.

(2) increasing homeownership among households because of that price stickiness (and probably because of public policies initiated in the 1990s to increase ownership).

(3) regulatory limits to multi-unit housing in high cost cities.

(4) regulatory obstacles that tend to favor tract housing.

Mass misunderstanding of these issues led to a public consensus that demanded a nasty and unnecessary recession, the roots of which go back to 2006. If we really want to solve the housing problem, we need to reduce regulatory obstacles to building, increase access to mortgages or other methods of home ownership, and stop second-guessing prices. There has been much ink spilled about the savings glut. Housing can soak up a lot of capital, but it can't do that if we don't allow for it to be developed. Ironically, we need a more pro-housing public policy to solve the savings glut problem. (Not a pro-homeowner policy. We need to get rid of pro-owner tax subsidies. As I have said, we need to make it easier for most households to build or own a house, and we should want marginal households to be indifferent to doing just that.)

If we allowed more building, rents would fall. This should be uncontroversial. And, rent inflation has been high for some time. This would have a slight downward effect on home prices. But, it will only come with housing expansion, mortgage expansion, and probably, initially, significant price increases. But, I think this might lead to a secondary effect, which could be more controversial, conceptually. And that is that all that extra housing will serve as a vehicle for capturing the global glut of savings. This will allow interest rates to revert back toward long term norms, and, ironically, it will lower home prices, because much of the rise in home prices has been related to low long term interest rates.

Our problem wasn't that we had a housing bubble. Our problem was that housing can serve as a highly useful supply of investment that global savers and baby boomers are desperate for; a combination of market frictions and regulatory burdens have prevented its full development. Since housing couldn't completely meet this demand through quantity, it met it, in part, through price. If we allowed this market to function more freely, we would all benefit. Housing consumers would have much lower rents, and global savers would have higher real interest rates on low risk investments. Both of these things - low rents and high interest rates - would lower home prices.

Since we collectively got all of this wrong in the 2000s, and continue to get it wrong, home prices soared in the 2000s, and they will continue to rise in the current recovery. It looks to me like there is a consensus to throttle the recovery again, instead of facilitating the growth of the real housing stock. That is very unfortunate.

PS. As I post this, I see that David Henderson has shared some comments from Ben Bernanke and others that relate to this issue.

Monday, April 20, 2015

Benjamin Cole recently unearthed a 1992 piece from Milton Friedman in the Wall Street Journal, complaining that Fed policy was too tight. I do think there are an interesting number of similarities between the recoveries after 1990 and 2007.

Between 1989 and 1996, Price/Rent ratios declined by about 15% (and more like 23% in the Case-Shiller 10 city index).

The delinquency rate on real estate loans reached more than 7% in 1991. The delinquency rate on real estate loans in the recent crisis didn't outpace that mark until the second quarter of 2009. (By that time, home Price/Rent values had plummeted by 25% or more, depending on the price index you use. It has become fashionable, in hindsight, to blame irresponsibility of households and banks for the recent crisis. But, this measure suggests that, compared to 1990, both households and banks were more stable. Home values had to fall much farther and more steeply in the recent crisis than they did after the 1990 recession before delinquencies and bank failures reached similar levels. Higher inflation meant that the delinquencies in 1991 came without any notable drop in nominal home prices, while nominal home prices by early 2009 had fallen by more than 20% by the time delinquencies topped the 1991 level. If the crisis was an inevitable result of high delinquencies, then why didn't home prices, and the wider economy, collapse after 1990?)

Nominal growth of mortgages was low until 1998.

Growth in Loans and Leases in Bank Credit at the commercial banks appears to have suffered a permanent drop from the long term trend, and continued along the new trend path without reverting to the old trend.

After a brief increase during the recession, inflation dropped to a descending trend after the recession, so that inflation rates after 1992 have remained much lower than the pre 1992 levels. (This trend has generally been in place since 1980.)

So, why was the 1990 recession less severe than the 2007 recession?

Some things which were different:

Inflation was over 4%, and rose to over 5% during the 1990 recession. Even though inflation was in the midst of a sharp secular decline, 4% left a lot of room for price flexibility and real wage adjustments. It also meant that the zero lower bound was not relevant, that bond yields could reach natural equilibrium prices, and that holding money was associated with opportunity costs.

In addition, risk premiums were low and declining in the 1980s and 1990s. This meant that, even without the inflation premiums, real interest rates tended to be high. (Low real long term interest rates tend to be associated with high equity risk premiums.)

In the comments on previous posts, Travis V has pointed out that the persistently high equity risk premiums we have seen over the past decade could be related to the current low levels of inflation and interest rates, which cause demand shocks to be sharper than usual. I agree. (The previous period of high equity risk premiums might have been related to the opposite problem - instability because of excess inflation in the 1970s.)

I also wonder if the target inflation rate needs to be a little higher than it had been in the past because the large components of education and health care, which have tended to be inflationary and tend to capture an increasing portion of expenses, mean that total compensation might need to rise at a rate quite a bit higher than zero before growth in cash wages can become positive.

And I also wonder how much the current high equity risk premium reflects the current state of the corporate competitive environment, where, especially in the tech sector, firms capture high profits and valuations which are based on intangible values and network effects, and can quickly vanish. Possibly, these high risk premiums simply reflect a large influence of the volatile state of global technological advancement on equity markets in general - creating a bifurcation of (1) capital at risk with unavoidably high variances in potential outcomes and (2) low risk capital which must balance this problem in the aggregate market portfolio.

Finally, employment was affected by unprecedented pro-cyclical policies during this cycle, which were not in place in 1990 to nearly the same scale. The last graph here reflects an estimate of the unusual level of very long duration unemployment after the 2007 recession, which I attribute to the unusually generous extension of unemployment benefits. In all previous time periods, very long duration unemployment could be pretty accurately predicted by using shorter duration (less than 26 weeks) unemployment levels. After the 2007 recession, this longstanding relationship broke down. This graph shows the estimated effect this had on unemployment levels. Without that effect, unemployment in 1990 and 2007 look similar, except for the brief spike above 8% in 2009, which quickly fell back to about 7% in 2010. Five years after peak unemployment, in 1997 and 2014, the unemployment rate was just falling to below 5% (after removing the remaining very long duration unemployed). But today, there still remain more than 0.5% of additional reported unemployed workers with very long unemployment durations (currently averaging more than 100 weeks).

If inflation had been higher, equity premiums lower, and labor policy less pro-cyclical, maybe the aftermath of 2007 would have looked much more like 1990. Maybe the disastrous FOMC decisions, especially in 2008, look especially damning because we have seen the results, but maybe they were simply following the general tenor of a policy stance that had been working pretty well for a couple of decades, and by 2008 the slow march of these trends had created new downsides to that policy stance that we hadn't had to deal with before.

How much different would things have turned out if homeowners in 2008 were sitting on 10% or more of additional inflationary gains in their home prices and rent values, just as a cumulative effect of general inflation? What if the natural neutral rate of interest had been a couple percent higher? It's not hard to imagine a much different scenario. Maybe the Fed hadn't changed so much in 20 years, but the nominal economic landscape they had shaped simply had become less forgiving to tight monetary policy in ways we didn't appreciate until after the crisis happened.

As usual, I suspect that our determination to blame this all on greedy financiers and lemming-like homebuyers will cause us to miss the important lessons here.

Friday, April 17, 2015

Core minus shelter inflation appears to have bottomed out. We have three straight months of C-S inflation at 0.1% or higher for the first time since 2Q 2014 and March C-S inflation came in at 0.2%, which is the highest reading for a single month in more than 2 years.

Shelter inflation for the month was 0.27%, which is about the trend level we have seen since the mid 1990s, except for the aftermath of the 2008 crisis, where the drop in incomes became sharp enough to cut into housing consumption. I attribute this to a long-running shortage in housing, which was only partially mitigated during the housing boom of the 2000s.

The post QE mortgage recovery story continues to look plausible. One danger was that non-shelter inflation would continue to fall, and that the economy wouldn't have the legs to keep recovering without QE. I think the economy is close enough to systemic recovery now that real interest rates and real wage growth should be strong enough to allow for non-distorted economic activity even if inflation is somewhat soft. The danger was mainly in sharp deflation. It looks like we have avoided this. Forward inflation expectations appear to have stabilized, also.

If mortgages begin to expand, we should see a convergence of shelter inflation and non-shelter inflation. (This convergence will probably be associated with rising home prices, which will be erroneously associated with housing inflation.) This happened from 2002 to 2005, also. This should buoy real incomes and help keep the Fed from throttling liquidity, until the "bubble" police start begging for some more self flagellation. As long as liquidity is made available, returns (and prices) of homes and real long term bonds should also converge to long term trends.

A commenter at The Money Illusion recently noted two articles from 2001 and 2002 that were already declaring a housing bubble. The commenter meant this as evidence that there was a bubble and that it was something regulators could have foreseen. Of course, anyone who bought a house in 2001 or 2002 would have done quite well, and would still be sitting on substantial capital gains. From my perspective, those articles are evidence of how the bubble narrative was preordained as an explanation for any economic dislocation, well before the events of the boom and bust played out.

Those two articles (especially the second one) contain several common anti-finance shibboleths. From the first article:

Supply is beginning to outstrip demand...(Robert) Shiller worries about an ominous mix of overdevelopment, inflated home prices and rising consumer debt.

From the second article:

(H)omeowners have every reason to keep their homes expensive. And, by coincidence or design, as home-equity finance has gained popularity, so too have no-growth movements, restrictive local zoning laws and other policies that constrain new-home construction.Demand soon outstrips supply.

Both of these things, as any sophisticated observer will tell you, are products of some sort of conspiracy of some group of financial interests (builders, rich homeowners and investors, etc.) to keep pushing their "paper" profits up. Paper profits, of course, being a sort of "Wall Street" demon pretender of the sort of incomes and gains that real people create. We know that the economy is composed of (1) Wall Street power brokers whose machinations, even when they are direct contradictions of other supposed machinations, push prices to and fro, for the sole benefit of financial insiders and "the rich" and (2) helpless rubes who, as a group, chase bubbles, like addicts, in a fruitless attempt to escape their ever-descending economic state. These things, we know, a priori.

The red team/blue team drama has latched on to these notions, which are firmly rooted in banal cognitive biases, because it allows for much more predictable arguments about cause. If our understanding of outcomes is allowed to adjust for experience and empirical review, political debate will be complicated. If we can all agree on unchanging, false premises, then we can get to the important work of arguing about whether the canard was the fault of Republicans or Democrats. And, since most of these markets involve complicated tradeoffs, we can all agree on things, like, that rising home prices are lining the pockets of the 1% while they also simultaneously make it harder and harder for working families to afford a home. Every transaction includes a buyer and a seller, which is sort of like magical pixie dust for populist rhetoric.

Only a naïf would suggest that prices are, you know, information about underlying economic fundamentals, or that reasonable people, upon witnessing a massive increase in prices among the most widely distributed middle class asset, might consider it a sign of a very healthy middle class.

....Anyway, I'm getting off track here. As in the 2000s, where markets function, prices tend to get corralled into fairly efficient equilibriums, even when there is pretty widespread conscious irrationality. So, as long as liquidity is somewhat reasonable, this convergence should be fairly inevitable. But, since these irrationalities are expressed politically, there is a decent likelihood that we will see another dislocation eventually. But, until that happens, the return to real estate should converge to the long term relationship with real bond returns, as shown in this graph. (Bond returns were probably higher in the 1980s because nominal bond yields reflected an inflation uncertainty premium. However, if that wasn't the case, then this long-term relationship would suggest that home prices were too high in the 1980s and 1990s and were normal in the 2000s. I don't think anyone argues that.)

Bond and home prices are about 2% away from their widest typical relative returns.

As mortgages expand, home prices should rise, creating a sort of virtuous cycle of liquidity creation. Forward inflation expectations of about 2.5%, with real long term interest rates around 1.5% (nominal rates of 4%) would equate to real estate yields of about 3% - 3.5%, which would be associated with a decent rise in nominal home prices.

Weekly readings in the Fed's H.8 report on bank assets can be a bit noisy, but this week's numbers seem to confirm a new growth rate that is kicking up toward 1% per month. This graph shows Closed End Real Estate Loans outstanding, both seasonally adjusted and not adjusted.

There is a monthly cycle with these loans, and the March to April comparisons have been strong. All in all, I'd say today's reports are tentatively good news.

Wednesday, April 15, 2015

I stopped playing colleges, and the reason is because they’re way too conservative.

How can this statement make sense? Here is a simple way of imagining US politics. I included a version of this, in my post on jubilee.

This could use less loaded language. High respect here means being careful
about changing or controlling something. Low respect means being more
willing to change or control something.

Let's begin with conservatism. It is kind of the core of the natural state of human community, which was surely made possible by our biological tendency to strongly favor our tribe, our tribe's leaders, and our tribe's idiosyncrasies. Loyalty to our received institutions is the core value here. There's a place for that value. There is real value in the Burkean sense of trepidation about changing institutions. Capitalism creates a constant stream of challenges to status quo arrangements. But, the American Constitution, one of our received institutional foundations, is the cornerstone of American liberalism and capitalism, so American conservatives are in the awkward position of defending the very system that inevitably speeds adaptive changes in status quo moral norms. This is probably one of the lucky accidents of the modern West.

Libertarians tend to have some affiliation with conservatives in the U.S. I think that this is because libertarians share a respect for our liberal Constitution. But, where conservatives emphasize the duty of individuals to serve institutions, libertarians see the value of institutions as a product of how they serve individuals. Libertarians can be protective of the Constitution or religious institutions, but are more likely to view them from a Hayekian perspective - that these institutions are emergent human creations. Whether it is the law, the market, or religion, we may see imperfections and sources of unfairness, but with emergent systems, we must be wary of the uncountable number of interactions and relationships that escape our limited observations. Just as we wouldn't want to roll through the rainforest, say, killing all the large predators, libertarians are wary of popular proposals aimed at broadly manipulating public behaviors and outcomes, because of possible unintended and unseen consequences. Libertarians are Burkean liberals, and they defend emergent order, in the form of markets and free society, and core institutions that promote their peaceful incubation.

Moving around the circle, liberals are much like libertarians, but with less trepidation about changing institutions. From conservatives' point of view, liberals frequently seem anti-American, or anti-religious. That is because it is important to liberals that their institutions - institutions that they have control over and that have control over them - are just, and they are not hesitant about calling out their own institutions when they disagree with them. This is also a product of the modern West - a sense that we aren't just custodians of received institutions, but that we are responsible for correcting our institutions when they are in error. Libertarians and liberals each generally value both limited government and democracy, but liberals tend to favor democracy where libertarians favor limited government. For liberals, democracy represents the power to perfect our institutions. The Bill of Rights might be the best American example of liberalism, with the 1960's Civil Rights battle as its most recent apex. And, when liberalism triumphs, in hindsight, it is usually a universal triumph. The Renaissance, the Reformation, the Enlightenment, and the Industrial Revolution describe a multi-century process of the triumph of individuals over institutions.- the triumph of broad progress over imposed status hierarchies.

Moving from liberal to progressive, we move from a sense of perfecting institutions to serve individuals toward a sense of perfecting institutions to perfect individuals. Where conservatives would press others into a world that once was, progressives would press others into a world that never was. Where liberals would mold existing institutions to make people free, progressives would mold existing institutions to make people behave. Here, we have another accident of history. The Civil Rights advancements of the 1960's were a great liberal victory. But, we can divide those advancements into two categories. The more libertarian victories were changes that reduced governmentally imposed discrimination. These were changes that allowed institutions to better serve individuals. The more progressive victories were changes that imposed rules on private citizens. Even though the core victories were libertarian victories, the progressive changes became a part of the package of changes we identify with the Civil Rights era, and libertarian opposition to those elements meant that progressives took the mantle as heirs to Civil Rights liberalism.

I say this is an accident of history, because progressivism is decidedly illiberal. As with all of these political conceptions, there is a core of virtue here. The progressive core is a sense of justice - of righting past wrongs. We need this, just as we need the sensibilities held dear by the other wings of political ideology. This sense of justice - of fighting oppressors - leads to categorizations. Rich vs. poor. Majority vs. minority. Men vs. women. Employer vs. employee. These categories can become the core principle itself. Progressive policy positions are usually a reflection of the need to rebalance power among these groups. Where liberalism demanded individualist equality under the law, progressivism applies the law based on group identity. Progressive policies are usually associated with positive liberties. In commercial contexts, this usually means that employers and capitalists are coerced for the presumed benefit of employees and consumers, through redistribution, progressive taxation, and a host of norms imposed selectively on private for-profit firms, such as workplace and wage restrictions and anti-discrimination rules. Positive liberties generally, in practice, equate to the selective denial of negative liberties.

So, while this is rooted in a quest for justice, in practice it is essentially ad hominem. This article is a case in point: "Wal-Mart’s new scheme to prey on America’s poor". Note that the article makes no attempt to even create a poorly constructed straw man set of expectations. Wal-Mart is creating valuable banking services for poor people, which is bad...because it's Wal-Mart. There is a movement to create low income banking services through the Post Office. The movement must insist on preventing Wal-Mart from establishing banking services and must implement them politically through the Post Office, because the Post Office represents control. Imagine if both the Post Office and Wal-Mart start offering banking services. Where do you imagine most poor people will choose to bank?

The attempt at egalitarianism and at leveling social injustices arises from a virtuous sense of justice. But, in practice these ideas serve as a sort of original sin - a problem that can never be rectified - and thus morph into a permanent lineup of favored and disfavored groups. The writings of Robert Reich, Paul Krugman, etc. are infused with these explicit appeals to ad hominem. They talk about "The rich" or "corporations" or "Wall Street" as a monolith, with rhetorical tactics that would be clearly offensive if directed at an ethnic group or race. The message is "They're different than you and me". Progressives become modern Pharisees. Advocacy, OWS marches, and Facebook status updates are like loud public prayers at the temple. Corporations and investors are perpetually unclean in the eyes of the unbending law of egalitarianism.

Progressives oppose Citizens United*, for instance, in spite of liberal principles regarding political speech, explicitly because some of the plaintiffs are associations formed to facilitate shared ownership of productive capital. Corporations own capital - a progressive original sin. If your core principle is that rights should be enforced selectively to counter power, and capital represents power, then "getting money out of politics" seems principled. But, really, there are any number of sources of political power - all of them distributed unequally. Progressives are simply singling out the one source of power that is associated with their chosen out-group and selectively attempting to remove it from the realm of protected rights. There is no principled difference between this position and, say, preventing gay couples from marrying or keeping minorities out of good schools or limiting property rights for women. Progressives will argue that selective treatment is warranted here, as a way to correct for power imbalances. But all sectarians think they have their own good reasons for selective treatment. Progressives are applying conservative (or, more precisely, sectarian) principles. They have simply changed who's in and who's out.**

Thus, progressivism in power is crude conservatism. There doesn't seem to be an ideological mechanism for progressivism to transmute into conservatism, as there was from conservatism through libertarianism and liberalism. The mechanism is power. In power, progressivism becomes conservatism, but not the conservatism that we are accustomed to, which at least defends our received liberal foundations. It is a pre-liberal conservatism, explicit in its insider-outsider identity-based favoritism, and decidedly anti-bourgeois.

* I am endlessly amused by the fact that opponents to Citizens United, who generally use slogans, such as, "Money is not speech, and human beings, not corporations, are persons entitled to constitutional rights." fight this ruling by forming corporations, associations, and affiliations, and with a united voice making public statements of conscience. Here is a petition that implores boards of trustees, congregations, and committees to demand that "corporations aren't persons and money is not speech" and ends with "This work is made possible by the generosity of individual donors and congregations." Clearly, these groups are engaged in reducing the rights and status of commercial producers. I am curious about the motivations that cause them to avoid language that would make this more clear in their petitions. This disconnection does not come from a shallow or conscious place.

** Of course, I'm being unfair to conservatism here. Prejudice is sometimes a kind of a side effect of conservative biases. Progressivism has made a prejudicial viewpoint a core principle. Think of how frequently the progressive media will simply note that something good happened to the rich, or whites, or corporations, or men, and this is understood to be bad news. If we think in progressive terms, we can see how there is some base virtue at work here - a desire to pull outcomes toward a mean. But, if we think about this in terms of avoiding a corrosive mindset, it's really quite nasty. With any prejudiced point of view, our biases start to inform our interpretation of the world and our acceptance of perceived facts. If prejudice is a central virtue, how in the world can you expect to interpret facts with a remotely objective perspective, especially if you are surrounded by like minded ideological partners. Think of how biased and ill-informed people generally are who openly espouse white supremacy, misogyny, and nativism. Accepting that progressive prejudices are ground in a sense of justice, still, why would we expect them to be any more reasonable or informed than unjust prejudices? Even the wise Benjamin Franklin famously wrote a friend about German immigrants, "…Not being used to Liberty, they know not how to make a modest use of it; and as Kolbern says of the young Hotttentots, that they are not esteemed men till they have shewn their manhood by beating their mothers, so they seem to think themselves not free, till they feel their liberty in abusing and insulting their Teachers…." And, he didn't consider it a virtue to dislike Germans. This mistake was by accident because he was kind of put off by them. Imagine how ignorant he would have been if he considered being anti-German to be a morally uplifting core principle.

Being a financial nerd around progressives is, I suspect, like being an evolutionary biologist around creationists. Creationists would constantly be talking about your favorite subject. You might at first think, "Oh! Yeah! Seemingly irreducible complexity! What a fascinating topic. How could these mechanisms evolve?" But, you would soon find that their interest in the topic is to specifically not learn those things. Such is the case with progressives and inequality, or the balance between wages, interest, and profits, or markets in general. Progressive approaches to economic and social matters are informed by the goal of pulling down the status of commercial associations. This does not lend itself to objective review of stochastic statistical information that moves around a tentatively stationary mean.

Take an issue like income inequality - a favorite issue today. To the extent that it is an interesting subject - which it seems to be to many people - it is the product of a complex web of causes, such as the revolutionary global explosion of the internet and digital technology, the empowerment and education of women, the extension of education and retirement in our lifecycles, changing household composition and size, the new trend of lower income being associated with more leisure, etc. Yet almost all of the discussion revolves around factional political issues like tax rates, which probably are a small part of the story, or growing corporate profits, which is empiricallyincorrect.

The reaction to much economic progress makes me think of this scene from Seinfeld. (George is basically demanding that any change in his dating life is a Pareto improvement.) Whenever I hear something about foreigners or robots or some other source of new productivity taking everyone's jobs, (or some new technological or cultural advancement that might temporarily change income distributions or might lower and raise the social or economic status of various groups in complex ways) I want to ask, "Do you want to be able to get your hand out of her hair, or do you not want to be able to get it out?":

Tuesday, April 14, 2015

There is the problem in macro data of considering the effect of inflation on different types of households. We tend to discount nominal income numbers with national inflation measures, but over long periods of time, we really don't have a good idea of how cost of living has changed for different households. Depending on geography, socio-economic status, etc. the effect of individualized cost of living adjustments might even dwarf the kinds of trends in incomes that dominate public discourse. I was reminded of this recently when I was looking at rent inflation statistics. Rent for housing amounts to about 30% of the component weights in the CPI. And, this category is specifically divided between home owners (Owner Equivalent Rent for Primary Residence - about 23%) and renters (Rent for Primary Residence - about 7%).

So, for renters, 23% of the CPI is, by definition, a cost that is entirely missing from their actual basket of goods and services. Now, over time, housing supply for owners and rents does have some marginal substitutability, so they have some relationship. But, they can diverge quite a bit. Owner rent inflation cumulatively moved higher than renter inflation by nearly 10% in the late 1990s, but renter inflation has caught up with it since then.

I think the difference between these inflation categories can be meaningful in my eventual analysis of tax policy's effects on home prices. There are types of housing that are more amenable to renting, usually multi-unit structures. These generally have more community areas and less privacy, which act as a natural mitigation to the principal-agent problems that arise from having a tenant who is not the owner. The close neighbors and property managers help regulate the tenant/owner relationship.

For home owners transitioning from renter to owner, ownership itself adds value to the property by eliminating these principal-agent problems, and this added value is maximized by owning a separate, private residence that isn't regulated by close neighbors and managers.

Obviously, on the margin, there are counterexamples. A small portion of the real estate market consists of condominiums. And, many neighborhoods try to capture some benefits of communal regulation through Homeowners' Associations. But, for our purposes in this analysis, the fact that the owner and renter market are highly segmented is useful.

Looking at the difference between owner and renter inflation, we see a sustained rise in owner inflation from the mid 1980s to the mid 1990s. This coincides with the new importance of the mortgage interest deduction in 1986. So, we can think of this as a signal of added demand in the homeowner market, as households moved to capture the added after-tax value of owning a leveraged home. We would look to see how much of an increase in homeownership there was, and estimate the added consumer surplus captured by homeowners.

But, surprisingly, during this period, there was no rise in the rate of homeownership. We need to think about the effects of the mortgage tax deduction carefully. As this paper notes, and I discussed here, the mortgage interest tax deduction is overwhelmingly captured by high income households. In fact, real estate leverage tends to increase with income. So, this tax benefit went overwhelmingly to households who already had pretty universal homeownership rates among households who wanted to be homeowners. So, the effect of the mortgage interest deduction is pretty simple. The entire benefit went to owners.

If there had been an increase in ownership, we would need to estimate what marginally extra dollar of after tax value enticed each marginal renter into ownership. If the tax benefit added 5% to the nominal value of a property, it may be that renting was worth 4.9% more to the individual, and so a 5% increase in owner-occupied housing consumption would only represent a 0.1% increase in utility for the household. But since ownership was flat, we can estimate the gain to homeowners with the rise in owner-occupied housing consumption.

The benefit had two effects. The demand for homes by owners shifted to the right, because home consumption was now relatively less expensive, after taxes, than other forms of consumption. This increased real housing consumption. But, to the extent that there are limits and costs to the availability of housing, because of the scarcity of land and materials, regulatory limits, etc. some of this extra demand will show up as inflation, specific to owned properties. That shift upward in owner consumption would also be associated with a decline in renter consumption to the extent that there is competition for supply between the two markets That is what we see in the graph above for the decade after the mid 1980s.

This chart suggests that amounts to more than 1% of GDP. The Wharton paper mentioned above puts it at about 1% of GDP in 2003.

The value of the non-taxability of imputed rent is a much larger value. (The Wharton paper estimates it to be nearly twice the value of the mortgage subsidy.) This would explain why the mortgage interest deduction didn't move homeownership higher. There were already such large tax advantages to ownership that any household that valued ownership at all (and even some who would have preferred renting in a tax neutral context) were already homeowners.

So, while this increases the possible effect of the mortgage tax deduction, compared to the estimates I used at the beginning of this series, the effect of the capital gains exemption on housing might be less than I thought. As we can see in the first graph, this inflation signal goes away after the mid 1990s. I think what has happened is that the capital gains tax rate on non-housing assets was reduced at about the same time that the exemption was strengthened in housing. These may have had offsetting effects.

So, while there may be less of a capital gains exemption baked into current home values, this could suggest danger for future capital gains tax rate increases. If capital gains tax rates are increased, it could lead to a new inflow of capital into housing which we avoided in the 1990s because of the tax rate reductions.

So, what did happen in the 1990s and 2000s? One of the surprising details of Matthew Rognlie's recent work that I think has gone unnoticed is that, while it is true that the transfer of income from labor to capital has gone to housing capital, not to corporate capital, none of the gains to housing capital came during the housing boom.

As we can see in Rognlie's graph here, and in the following graph from one of my previous posts, from the mid-1990s to 2007 total capital income to housing was level, at best. The gains to housing capital came before 1995 and after 2007.

I have explained how the pre-1995 gains might have come from the inducement from the mortgage tax deduction for homeowners to increase their nominal consumption. The gains after 2007 are clearly excess gains from limited access. Homeowners are earning excess returns because supply is limited by the hobbled mortgage market.

So, the boom of the late 1990s and 2000s wasn't a product of new demand from homeowners. Nominal home values were being pushed up by outside forces (manifest in low real long term interest rates, mainly). This is corroborated by the fact that owner inflation was not high during that time, and owner consumption (gross rent) leveled off after 2000.

As I have argued previously, the sharp rise in nominal home values, and frictions in the housing market made house prices sticky and kept supply from rising enough to meet demand. So, interest rates were pushing up Price/Rent ratios, and the lack of supply was pushing up rents for both renters and owners. The flippers and speculators weren't creating a bubble, they were just capturing the arbitrage profits of sticky prices (which is a more reasonable description of typical speculator behavior across markets to begin with).

This is mistitled. Home prices are not included in the graph.

Here is a comparison of shelter inflation with Core CPI, which removes some of the food and energy noise out of the comparison. Notice that after a period of shelter inflation from 1985 to 1988, there isn't any net excess shelter inflation until the mid 1990s. This suggests that, even though households weren't switching from renting to owning, there was a gradual shift among homeowners to consume more housing while renters shifted to consume less, because of the unbalanced effect of the new tax subsidy on demand that favored owners and caused prices to rise in properties held by owner-occupiers relative to rented properties.

Homeownership started climbing in 1995, which seems to be related to policies like the evolving Community Reinvestment Act. This might have led to some of the higher owner inflation that persisted until about 1997 (in the first graph above). But, after that, shelter inflation in general continued to run high, but not particularly for owners.

I have come to the opinion that the CRA was a largely beneficial policy. It looks to me like it moved several million middle-to-upper-middle class households into homeownership who were previously held out of the market for home ownership for reasons other than price. That is all for the good. The fact that much of the increase in the homeownership rate increase happened before nominal home prices began to rise and much of it happened without leading to owner-specific rent inflation suggests to me that these marginal new owners weren't pushing up the Price/Rent ratio on homes. They were consuming homes as owners instead of renters, so there was some decline in renter expenditures and an increase in owner expenditures, in terms of Gross Rents / GDP. And, there was some total increase in Gross Rents/GDP because access to home ownership was allowing these households to capture the gains from eliminating the principal-agent problem that exists in rented residence. But, the intrinsic Price/Rent value of the homes these households were buying wasn't any higher than it had been for existing homeowners, so this movement into homeownership didn't, itself, lead to rising implicit rents and home prices.

All of this suggests that, outside of the immediate aftermath of the GDP collapse in 2008, there has generally been a shortage of housing, first from the inability of prices to adjust in the face of falling long term real interest rates, and second from the collapse of mortgage funding.

I have previously been somewhat muted in my expectations for housing starts going forward, because of widely known demographic trends, but there could be a large amount of unnoticed housing demand that has been waiting for 20 years to be supplied. The recovery for homebuilders, if the banks are allowed to fund it without everyone crapping themselves about it, could be much higher than the current marginal expectation.

Further, if the 10% cumulative rise of owner inflation over renter inflation in the late 1980s represents the tax arbitrage value of the mortgage tax deduction, then we should expect a further 10% recovery in owner-occupier home prices above the prices of renter-occupied homes, if mortgage markets are allowed to begin to fund growing levels of home purchases again.

PS. I suspect that there are many errors here, as this is quite complicated. If you know of a technical correction that should be made, please note it in the comments. That is your fee for having read it, accepted by the author on the honor system, as a free will offering. If you gained negative utility from reading this, however, please do me a favor and refrain from giving bad advice in the comments in retaliation. I am resigned to your goodwill.